Adam Shapiro – Post-Breeding Grounds for Rising Stars and Families (Capital Allocators, EP.319)

28:34And some of the elements of the pitch, you wouldn't even think necessarily to go try to verify. Where we've really evolved is how we deal with your question on the public side. On the public side, you have to be very focused on what sort of pitches sound smart. And of course, the classic is the short pitch. Everybody knows that if there are 20 hedge fund managers around the table and you want to sound the smartest, you do a really colorful short pitch. There's even, I think, some psychological research that says like cynicism, negativity, those things actually sound smart. And so you get to make fun of how dumb the management team is and how the business model is falling apart and you sound really smart.

29:13And so you have to be very careful, I think, in assessing public managers if they sound awfully smart. And by then, sometimes, of course, they just are. But sometimes I've just found it's easier, unfortunately, to make the wrong judgment. On the private side, that can happen. But the making of a private investment is a longer process. And so if you shadow it along the way, it's somewhat more likely, especially if you're aligned. We're going to take a quick break in the action to tell you about SRS Aquium. Want to make sure your M &A processes aren't stuck in the past? partner with a company that's been defining the future of dealmaking for nearly two decades instead.

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30:49Alignment is one of the most tricky concepts that there is in investing. Alignment, when I was sort of first starting out in investing, the concept was so oversimplified. It was just, okay, does everybody have skin in the game, loosely defined? And everybody, if the investment makes money, does everybody make money? And if the investment loses money, does everybody lose money? And that is a massive oversimplification. Let me give you an example of why that is an oversimplification. We at East Park have probably made 140 or so private investments. And a very small number of them, thankfully, have been poor investments.

31:28But a majority of those poor investments were cases where we broke our own rule. And our own rule is we must invest our money at the same time that the sponsor invests their money. So we need to go shoulder to shoulder from finding an opportunity through diligence and to closing. And we have found that a majority of our mistakes occurred when the sponsor was already invested and convinced us to follow their lead into an investment at a later point. Now, the classic definition of alignment would say that was fine. That manager has skin in the game. If the investment is successful, they're going to make money.

32:11If it's unsuccessful, they'll lose money. And the reality is we were not aligned because by the time we were evaluating the investment and making our investment decision, the manager was already along the opportunity. And by being along the opportunity, their skeptical eye, everything they do in diligence, the whole process of looking for flaws and problems had stopped. They were now in the mode of how do I take this thing that I bought, whether it's good or bad, and make it as good as it can be. That's not alignment in terms of making an investment decision. I wrote a long piece about this because there's so much to it that the way the alignment you have with a hedge fund manager, of course, evolves tremendously over time.

32:52And it really has nothing to do with the math. In the early days of a hedge fund, you're much better aligned with a manager, even if their personal capital is a lower percentage of the asset base, because they must succeed. They must put up good returns. It's not surprising that the data shows us very clearly that the best hedge fund returns are in the first five years of the hedge fund, because the manager, even if they're not aligned financially in terms of money in the fund, those early years must be successful for them to have the career they want and for their decision to go off on their own to have been a good decision.

33:23So that's a form of alignment that I think you only really start to appreciate as you really get experience in our world and you see how behavior changes. It's not exactly about skin in the game. It's not exactly about who puts up what percentage of the capital. What are some other examples of alignment that don't follow the traditional money flow definition? One is that's really underappreciated in terms of alignment is actually the alignment that comes from having a long, close relationship over many years or decades. So if there's a manager who I've known for a very long time, who is a very close personal friend, who has proven through the years that not only are they a really good investor, but they care about alignment.

34:11everything they do after you make the investment is about maintaining that alignment and so there's a personal element to alignment that has to do with your relationship with the person the character of that person them caring about alignment and that in many cases is much more important than just the financial flows of what do they put in and what do you put in it's because i know this person because i know they care about alignment i know that they're going to be incredibly focused on not making a mistake up front and then optimizing the outcome over the course of the investment through all the twists and turns it may take.

34:47So I want to circle away from the manager selection and talk about you spend all this time trying to find these great people. Ultimately, you're managing pool of capital. So how do you think about the objectives for the pool of capital that you're managing? I should describe a little what we do, which is we execute an investment strategy on behalf of a very small number of families. And we construct portfolios for them, which is the work product of, we think, these great managers across public markets and all different private markets, growth equity buyouts, real estate, what have you. And the guiding principle is that our families should have the option to spend 95 plus percent of their time not thinking about investing, but should have the level of care that you would expect if you were the Yale endowment and your money was being managed by David Swenson or now, of course, the many people he's trained and are at endowments all over the country.

35:48So our goal within that is to produce great returns. One of our core values is we're playing to win. So we're trying to put up strong returns while protecting capital in tougher years and doing that by constructing portfolios that are very diverse. So the work product of all these different managers ends up being very idiosyncratic and a lot are structured for downside protection. If you look through those portfolios, they look a lot like endowment portfolios. They have long public equity positions, they have short public equity positions, they have all different kinds of privates. And so we think that that combination of playing to win, trying to put up significant returns while protecting downside is the sort of thing that ought to be more available.

36:36But the way our whole sector is structured to service families doesn't necessarily promote that as much as it should. Other than play to win, what are some of the other objectives that you espouse for the pools of capital? We want families to have a very clear window into our process. And what they'll see through that window is that they'll understand who these people are who are producing what we think are great investments. So on the public side, we have about 15 to 20 hedge funds we're invested in. The families will have some sense of who those managers are. And as the family pools develop, there'll be 60 to 80 private investments with 30 to 40 sponsors behind them.

37:19And the families will have some sense of who they are. It should feel like I know who these great players are and I know what they're doing. And some investing is tangible and some is not. So I mentioned the hotel strategy. Our families can go stay at some of the hotels we own and that feels tangible. We've invested in a few consumer products that the families recognize and that feels tangible. So we want it to be just the right mix of having our families feel completely comfortable and free. again, that they can spend 95 % of their time not thinking about us and not thinking about investing generally, but maybe in the 5 % of their time, they get this incredibly efficient window into what we're doing, why it's safe, why it's special.

38:07I feel like this may be a reach, but you want your families to feel delight at being able to see this process that's being executed on their behalf and the peace of mind it gives them. And just this feeling that there's this quality being brought to bear for them. How do you think about the portfolio construction and risk management when you roll up these 80 deals, these 15 hedge fund managers? There are three ways to really determine whether your portfolio has some sort of hidden concentrated risk or not, right? Like we're really focused on not having concentrated risk, but having all these uncorrelated return streams.

38:48And so the three ways, first is statistics, right? You do your analysis on the portfolio and see how all the different positions are moving relative to each other. And that's one marker. It's a starting place. It's not definitive, but you can look at all your different positions and how they perform month to month. And that tells you something about whether they're correlated or not. The second and probably most powerful, I think, is to literally look at the positions, describe them, and then use judgment to determine whether they're likely to move together. And so that's where our process is really focused.

39:23And we really like investing in things that are just so clearly non -correlated with other things. Like we've had a theme investing in insurance companies in runoff, For example, we recently made an investment in a consumer business that was very asset heavy and the revenue is expected to decline. And one of the things I believe in terms of downside protection is you can protect your downside several different ways. One way is to have some specific hedge. Another way is to be high up in the capital structure, have some structural protection. And a third way I think is probably less appreciated is you can invest with the expectation that the thing you're investing in is going to shrink.

40:08And therefore, what GDP does, what markets do, what consumer behavior does really doesn't impact the outcome. And if it's expected to shrink, you also tend to be less dependent on multiples. So you're really insulating yourself from capital markets. We've invested that way several different times. Insurance companies in runoff are expected to shrink. We invested in a German bank that was expected to shrink as part of its business plan. We invested in a consumer business that was expected to shrink where enterprise value, rough numbers, is $200 million. And there's $200 million of assets that we didn't think we needed.

40:45So we could sell that off and recover our original cost basis. And then we could take a business that had rough numbers, $900 million of revenue, shrink get to $700 million, improve margin, and create something that's creating real income around it. And those are the types of situations where when you put on your judgment hat and you say, is this portfolio correlated? You look at that consumer business and you say, that is not going to behave the way these other things are going to behave in terms of correlation. The hotels we invest in are probably the most correlated with economic activity, but there are a whole bunch of mitigating factors.

41:24So we have a budget for investments that have some correlation with the broader economy. And we've used a fair amount of that budget on our hotel investments because we think there's some things that are very special about those hotel opportunities. Curious how this aggregate portfolio behaves like an endowment -like portfolio that goes about it quite differently, but may have, at the end of the day, different diversifying underlying exposures that are comparable. When we first created our business, we were very much inspired by David Swenson, the Yale endowment and the endowment model, but we also had quite a different perspective on how to build the portfolio.

42:01So some of the differences, first, there are a set of areas that endowments seem to like to invest in that to us seemed like poor returns on risk. And so those included for most of the 16 years we've been doing this, most of credit has fallen in that category. What people call core real estate, which is highly stabilized, very low cap rate, real estate, infrastructure, agriculture. Those are all things where I think in the matrix of there's low risk, high risk, low reward, high reward. And it goes without saying, we're trying to play in the low risk, high reward category. And I think those investments I just mentioned, we perceived as actually high risk, low reward, the thing you want flipped on its head.

42:51And so we avoided those things. We also did relatively little in venture, mainly because it didn't fit our investing model of external partners on the private side quite as well. So you could look at our portfolio and say, yeah, there are similarities with the endowments, but it's also quite different where we didn't do really anything in emerging markets on the private side, based on my prior experience there, we did relatively little in traditional long -only equities. And the thinking there, here's where we had to make a choice about what we thought was best for our family clients. And we felt that to the extent our families ought to have long -only equity exposure, they actually ought to do it away from us, not under the umbrella of Eastrock.

43:38People use this term OCIO, outsource CIO, and there are firms that are one -stop shop for a family and they'll do everything. Our feeling was that if it was our money, we'd actually like to see the capital in two places. One place is Eastrock, where we are managing long -term assets according to a certain process focused on these great managers and focused on smaller hedge funds and individual private investments. And we would want a separate home, simple brand name financial institution, relatively low fee and have the more traditional products there. And so that's how we set that up is what we would want for ourselves.

44:20And so we don't end up with these pockets of long only exposure that a lot of the endowments have. Now we have long stock exposure, obviously, through the hedge funds. Sometimes when we're talking about what we do relative to endowments, people will ask, well, isn't it very different because you're taxable and they're not? Isn't it different because they have to make a payout and you don't? I'll start with the second one first. We actually make payouts and they're more uncertain than what endowments have to make. So we tend to actually have to have a higher liquidity threshold in certain ways than an endowment would.

44:54And absolutely on the tax question, we're very focused on after -tax returns because most of the money we manage is for families that are U .S. taxable. How do you think about managing liquidity within the construct of your portfolio? It's one of the hardest things we do. We have models with many sensitivity scenarios around them. Because we have a small number of clients, the dialogue with families is very important. And so we have some sense of what liquidity they may need or want and how to sensitize around that. So if you look at the portfolios we manage for our families, they are comprised of cash, hedge funds, some of which offer liquidity in the near term, and then some private investments, some of which are illiquid for the very long term, some of which have already matured and there may actually be public stock at that point or some other way to get liquidity off of them.

45:50And so we are constantly updating our assessment of different liquidity scenarios based on the outflows, obviously. It can be new investments we make. It could be a family requirement. And then, of course, the inflows could come from families, could come from selling privates, could come from redeeming from hedge funds. We've never used leverage. So obviously very important to get that right with a cushion. So you started your career buying family businesses, managing money for a handful of families. There's this great aphorism that when you know one family office, you know one family office. What have you learned about these pools of capital, these family office pools of capital, and how that money gets managed in that ecosystem?

46:35A lot. one thing i've learned is the tremendous value of air traffic control and families that have a trusted employee and this is very important a trusted employee who doesn't identify as an investor and while the trusted employee is in some ways a protector and gatekeeper doesn't take that to an extreme. So that person is of tremendous value to the family. So some of our families have a gold standard version of air traffic control. And typically the background of that person is accounting. It can be law, it could be some mix, some prior experience as a CFO or a COO. And when I say air traffic control, this is somebody who understands the importance of information flow from family to, if there are other employees of a family office, employees, to the third -party providers, people providing the investment management, people providing trust and estates, other legal services, dealing with an operating company, dealing with personal real estate, art, dealing with philanthropy.

47:50having a person sit in the middle who is a protector but also open -minded but also wants to know who are the best of the best third -party providers and frankly doesn't scare them off through toughness or through a desire to protect territory or whatever it may be if that person is enabled they provide so much value to the family it's just a very simple concept but one of them said to me, my job is no surprises. And if I deliver that, everybody's happy. Nobody wants the phone call that we've got a liquidity issue. We've got an employee issue. Nobody wants those surprise phone calls. There are certain families that ought to have a large family office operation investment team or multiple investment teams.

48:34There are certain families that is perfect for, but for many of the others, and again, this is when I say for families who want to spend 95 % of their time thinking about something other than investing and other than the asset base and how it's protected and managed. For most of those families, finding a great air traffic controller, a small number of employees, and using world -class third -party providers for all the other key functions is a great solution. I'm surprised that I don't see that as often as I would expect. How about on the management of assets? Well, I'll start by breaking things down.

49:10There are families that sort of manage their own money, they create a family office. And then there is everybody else who uses a third party in some way. And I try to put myself in the position of the family. And what I would want is a team with which I have a close relationship. And for that to be possible, that team can't have too many clients. And I want that team to be spending 90 % plus of their time focused on the investing side of things. and I want them well aligned with me. I want their own money side by side with mine. I would want no worries about proprietary products versus third -party products and where the incentives are.

49:53I've been thinking about this a lot because when I look at our sector, define my sector as this world of managing family capital on some basis that is essentially outsourced rather than an in -house family office. I think our sector is nascent. Like I think in some ways what I just described to you, that seems pretty rare still that there are a sector is dominated by household blue chip names managing hundreds of billions of dollars. And then there's some boutiques doing a great job. I'm actually surprised there aren't more and that the sector isn't better understood. So, for example, I challenge you to find a good news article in any publication that goes through the various critique firms that provide some form of OCIO service and really compares them and contrasts them and talks about their track records.

50:47As you look out, what are you hoping e -struck will become over the next five or ten years? objective one is to be the best i'll call it post breeding ground of talent so the breeding ground of course is the place where all these folks trained we want to be the best post breeding ground so when it's time to leave those breeding grounds we want to look back and know that we partnered with these exceptional folks at these key moments in their careers, and we both benefited tremendously. They made some incredible investments with our capital, and so we succeeded, and we were the springboard to what they ultimately wanted to achieve.

51:38And so in a lot of cases, people come out of blue chip investment firm, and it's really not clear who owns the track record. And in those first few years, when they're on their own and we're putting up the capital for whatever they're doing, that's when they're building the track record. That'll propel them to what they ultimately want to achieve. And I want to look back and see a mosaic of these folks who were able to do that and achieve that. And then along the way, I want to build an absolutely phenomenal long -term track record. And so the nice thing about what we do with such a small number of families is that it's not like we have 30 track records or 50 track records or 100 track records.

52:20We really have one longest track record and then several other families have a very similar ones. And I want to be able to look back and show what we did relative to the great endowments and other comparables and feel like we really did something special. Adam, I want to ask you a couple of closing questions. what is your favorite hobby or activity outside of work and family? I have three. So one is relatively new, which is writing. I'm writing like crazy and you've helped me with this. So thank you. I have a newsletter I've been writing on LinkedIn where we didn't get into this, but coming out of college, I wanted to be a professor and an academic and an economist and think big thoughts.

53:02And this is sort of my opportunity to do that. and I've really loved it. So writing has really become a big hobby for me. So the other two, one is golf. I played golf competitively at a young age. I never got to be quite as good as I wanted to be, but I still love it. And I will, despite the frustrations along the way, I will still argue. And people, I think, sometimes think I'm crazy about this. I think golf is one of the great human inventions. I just think the opportunity it creates to have a lifetime journey of trying to get better at something and doing it with friends and being able to spend large chunks of time with friends, new relationships, old relationships, and do it in some of the most beautiful places in the world and have it go hand in hand with traveling makes it so, so special.

53:48And then the last one has to do with gardening and agriculture and gardens, which has also become a big pastime for me. And so I've been, for example, dragging my family to some gardens and learning more and more. We've become producers of hundreds of types of vegetables, not to mention we raise alpacas. We have four alpacas producing wool each year and as well as chickens and fruit trees and all kinds of things like that. What type of investment do you gravitate to like a moth to the flame? Once in a while, there's an opportunity to invest in a way that we call time machine investing, which is you get to invest based on a price and a set of terms that were established six, 12 months ago, and maybe sometimes longer.

54:38I think that can happen to anyone, but it happens to us probably more often than most because we're dealing with sponsors who may have tied something up and lived with it for a while. And then they sort of get closer to the end and they need capital for it for whatever reason, and we have the option to participate or not. Now, this has happened to us in many different sectors. It's happened with a gaming company where the price was set in the middle of COVID pre -vaccine, but there was an opportunity to invest post -vaccine. It happened to us with a B2B payments company where the price was set prior to a major customer win, and we were able to invest after that customer win.

55:21It happened in an accounting services investment where the deal just had quite a long time to mature before we got involved and things were going very favorably. You don't get to do it that often, but this is a subcategory within the you celebrate at closing category. Once in a while, you get this look at the end. And I think in a lot of cases, those will be some of the best investments you ever make. What's your biggest investment pet peeve? Deception, anything having to do with deceptive behavior, anything having to do with things that are promotional and the method for promotion is jargon that's meant to confuse, appealing to FOMO, misdirection, aggressive pitches that sort of get off the subject.

56:08I think I have a very low tolerance for that. When I see opportunities that are pitched based on some form of deceptive language or behavior, I have an allergic reaction. What was the best advice you ever received and what was the context that came to you? I'm going to mention two. Strategically, the best advice I've gotten is that 95 % of investing is sourcing. And we could argue what the right percentage is. And this goes back to Goldman Mondays and the operating partner model. If you see hundreds and hundreds of things each year, you're going to be able to pick a few that are just obviously good.

56:43And so there's no such thing as too much sourcing. You just want tons and tons and tons of ideas and you want an engine for producing those ideas. The more, the better, because the more you have, the less smart you need to be. One's tactical and has to do with the importance of competition in the context of something you're trying to achieve in investing. So we made an investment about 10 years ago where we took over a CDO. So we were able to control the CDO and liquidate it. And the primary asset of the CDO was a very unorthodox amortizing interest rate swap. And things were going well, except the counterparty to that swap.

57:21Once we got a hold of the assets of the CDO and we were liquidating them, the counterparty to that interest rate swap was a very large global investment bank. And our feeling was that that investment bank should liquidate the swap for fair value because the swap was so unusual that investment bank made the calculation that they could liquidate it at a huge discount because it would be difficult for us to go somewhere else. We were working on something with John Mack at the time, and he was great. And he had offered great advice on other things. So finally just said, John, I've got this problem.

57:54We're facing an investment bank trying to liquidate an interest rate swap. And they're just not being fair. He said, well, what are the other bids? I said, well, we don't have other bids. He said, get other bids. There was a good reason we didn't have other bids because everyone we would get another bid from would understand that the existing counterparty was the most likely to ultimately be the transacting party. So it was sort of a waste of time for anybody else to provide a bid. And the swap is very complicated and unusual and had sort of antiquated terms. It was a 1997 vintage CDO. So you could sort of imagine the language in the ISDA.

58:33But John's push got us to call in every relationship favor we could possibly get. So we did get two other investment banks to give us bids. We went back to the counterparty who said, here's what others are prepared to do. And we did successfully shame them into doing the right thing. Now, to me, the moral, sometimes we have to be reminded that if I have something, Ted, that you ought to buy, I expect you're the best buyer. I know what the market is. You know what the market is. And I can just go to you and say, here's a fair price and you might buy it. And sometimes that works, but very often it doesn't.

59:08So the notion of importance of competitive tension in getting to a satisfactory outcome when you're trying to sell something, for example, or trying to raise capital for something is so important and I think often underestimated. What teaching from your parents has most stayed with you? This really comes from my father. Two things that distinguish him. He has the least FOMO of anyone I've ever met. He is a person without any envy or any jealousy. And related to that, He, and this is back to where I get my low trigger on deception, he holds a very high standard of character for the people around him.

59:49And so his biggest trigger, of course, is someone who doesn't meet that character standard and who might have something that others covet. And I just watched him through my childhood into adulthood, just not coveting what others did. And that had a very big impact on how I think about the world. All right, Adam, last one. What life lesson have you learned that you wish you knew a lot earlier in life? This is a lesson you can know, but it takes a long time to be able to do it. And that is staying open -minded in the context of conflict. So when you have a moment of conflict, your body and your mind want to react a certain way.

1:00:27And if you can find a calmness, which is easier said than done, I think with age we mellow. And I think hopefully we get there over time. If you can find that calmness and you can stay open -minded in the context of conflict, things can just go so much better than if you don't. Adam, thanks so much for sharing all these insights on how you think about managers and portfolios and families and everything else you've been doing. My pleasure. Great to be here. Thanks for listening to the show. If you like what you heard, hop on our website at CapitalAllocators .com, where you can access past shows, join our mailing list, and sign up for premium content.

1:01:06Have a good one, and see you next time.